Global Economics

Rural Banks Know Something Big Banks Don't

Ken Hale is chief executive officer and 40 percent-owner of the Bank of Montgomery, chartered in 1903 in Grant Parish, La., by a group of men that included his great-grandfather. The bank was knocked over by Clyde Barrow and Bonnie Parker. It survived the Great Depression. During the bank consolidations of the 1990s it expanded across the Red River into Natchitoches Parish. “There’s no price worth me selling the bank,” Hale says. “I would live with the guilt for the rest of my life.” Not that there’s much reason to sell: Like most community banks, Bank of Montgomery, with $190 million in assets, came through the financial crisis unscathed. Hale’s problem is that other owners nearby feel the same way. He can’t find any banks to buy.

Until the early 1980s, most Americans made deposits and took out mortgages at a local bank, chartered and owned within their county. Almost all consumer banks, limited by statute, came in just one size: small. Deregulation in the ’80s and ’90s allowed mergers within and then across state lines, prompting bankers and economists to wonder about the ideal size of a bank. Acquire branches in other counties, and a bank can spread out its fixed costs. Get too many new branches, and a bank’s portfolio becomes too complex to manage. In the last year, several studies have broadened this question to include both size and location. It turns out small, rural banks make smarter loans.

Since 1980 the number of banks in the U.S. has more than halved, to about 6,000. Almost every bank that disappeared was tiny: It had a single branch and less than $100 million in assets. The lower-middle tier—lenders with between $100 million and $1 billion in assets—remained constant, both in number of institutions and total assets.

The Federal Deposit Insurance Corp. uses $1 billion in assets as a cutoff for its definition of a community bank, the vast majority of which operate in three counties or fewer. And while these smaller institutions have lost customers to larger banks, the decline has been far less dramatic in rural counties, where community banks still hold 70 percent of deposits. What hasn’t changed over 30 years is that the middle of nowhere still needs a bank.

Small banks in rural areas do a better job of what is generally considered Banking 101: underwriting home mortgages and loans to farms and small businesses. According to the FDIC, in every five-year period since 1991, a lower percentage of loans from community banks has gone bad. Richard Brown, the FDIC’s chief economist, says small banks have a competitive advantage with “nonquantitative” (sometimes called “soft”) information—knowledge of their customers and the local economy.

At the Bank of Montgomery, Hale points to what economists call social capital, where small, tightknit communities provide controls on the banks. “You can’t be greedy,” he says. “You can’t be devious. Because I gotta go home every day and see my two neighbors.” Both have mortgages with his bank; all three families attend the same Catholic church and school. “If I take advantage of them with some subprime loan, I gotta sit next to them,” he says. Two of his bank’s branches are in towns with fewer than 500 people. Treat a customer poorly, he says, “and there aren’t a lot more people to choose from.”

A 2012 paper, Small Business Lending and Social Capital, looked at loans backed by the Small Business Administration from 1984 to 2001. Loans from rural banks to rural borrowers, the study found, were only 70 percent as likely to default as those from urban banks to urban borrowers. The numbers get even better for what the authors call hyper-rural banks, those located in markets with fewer than 10,000 people. It’s not that rural loan officers are smarter or rural borrowers more trustworthy; when people know each other, loan performance improves.

Rural banks can afford to be a little less efficient, says Robert DeYoung of the University of Kansas, the SBA study’s co-author. They operate with little competition, but a small, unified community keeps them conservative and honest. Same goes for the customer. “Borrowers in smaller communities are less likely to default, because they can and do feel shame,” he says. “In an urban community, a defaulter can hide.” For those like DeYoung who study finance, such social capital is a relatively new concept. “We tend to study phenomena we have electronic data for,” he says. “Social capital is harder to measure.”

“We don’t make bad loans,” Albert Christman says. “They’re way too expensive to do.” He runs the $174 million Guaranty Bank & Trust in Delhi, La. He’s had offers for the bank, but like Hale he isn’t selling. In the last year, Guaranty Bank, which operates in three parishes along the Mississippi River, has expanded to Ouachita Parish, which includes the small city of Monroe. Large banks use scoring systems to make decisions about markets they don’t know well, he explains. “We don’t use those systems,” Christman says. “We only make loans in markets we do know.” He doesn’t make loans to people who run poultry houses, he says, because he doesn’t understand the industry.

Community bank owners are generally old enough to know better. Go to an industry meeting in Louisiana, Christman says, and you’ll see mostly men who lived through the bank failures of the late ’80s and early ’90s, when Texas, Oklahoma, and Louisiana were considered what he calls the Chernobyl of banking. “Once you go through that stuff, you don’t want to go through it again.” A 2013 study by the Federal Reserve Bank of St. Louis found that from 2005 to 2011 those three states had the highest ratio of “thriving” banks, with low loan-loss ratios and a high return on equity.

Both Hale and Christman want to expand. They’ve had to dedicate staff to make sure their banks comply with new regulations; the best way to trim that overhead is to buy another bank and spread compliance costs over a bigger institution. The FDIC’s Brown says the real problems are the slow growth in new loans and the low interest rates that have eaten into margins. Above all, Hale wants to make sure his bank remains independent until he can pass it on to his children. “If they want to get it and sell it, they’ve gotta live with that guilt,” he says. “I don’t have to.”